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# Chap015 - Chapter 15 Options Markets CHAPTER 15 OPTIONS...

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Chapter 15 - Options Markets CHAPTER 15 OPTIONS MARKETS 1. Options provide numerous opportunities to modify the risk profile of a portfolio. The simplest example of an option strategy that increases risk is investing in an ‘all options’ portfolio of at the money options (as illustrated in the text). The leverage provided by options makes this strategy very risky, and potentially very profitable. An example of a risk-reducing options strategy is a protective put strategy. Here, the investor buys a put on an existing stock or portfolio, with exercise price of the put near or somewhat less than the market value of the underlying asset. This strategy protects the value of the portfolio because the minimum value of the stock-plus-put strategy is the exercise price of the put. 2. Options at the money have the highest time premium and thus the highest potential for gain. Since they highest potential gain is at the money, the logical conclusion is that they will have the highest volume. A common phrase used by traders is “avoid the cheaps and the deeps.” Cheap options are those with very little time premium. Deep options are those that are way out of or in the money. None of these provide profit opportunities. 3. Each contract is for 100 shares: \$7.25 × 100 = \$725 4. Cost Payoff Profit Call option, X = 90 13.44 5.00 -8.44 Put option, X = 90 7.03 0.00 -7.03 Call option, X = 95 9.80 0.00 -9.80 Put option, X = 95 9.00 0.00 -9.00 Call option, X = 100 7.35 0.00 -7.35 Put option, X = 100 11.66 5.00 -6.66 5. If the stock price drops to zero, you will make 96.14 – 6.47 per stock, or 89.67. Given 100 units per contract, your total potential profit is \$8,967. 6. Break even = 40 + 4.50 = 45.50 7. a. Maximum loss = 4.25 + 5.0 = 9.25 b. Profit / loss = 58 – 50 – 9.25 = -1.25 c. There are two break even prices: 59.25 and 40.75 15-1

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Chapter 15 - Options Markets 8. c is the only correct statement. 9. The collar involves purchasing a put for \$3 and selling a call for \$2. At all prices your net proceeds will be \$39 per share. Given 5,00 shares, you will make 5,000 x 39 = 195,000 when the position is closed. 10. In terms of dollar returns: Price of Stock Six Months From Now Stock price: \$80 \$100 \$110 \$120 All stocks (100 shares) 8,000 10,000 11,000 12,000 All options (1,000 shares) 0 0 10,000 20,000 Bills + 100 options 9,360 9,360 10,360 11,360 In terms of rate of return, based on a \$10,000 investment: Price of Stock Six Months From Now Stock price: \$80 \$100 \$110 \$120 All stocks (100 shares) -20% 0% 10% 20% All options (1,000 shares) -100% -100% 0% 100% Bills + 100 options -6.4% -6.4% 3.6% 13.6% All options All stocks Bills plus options S T 100 –100 0 – 6.4 Rate of return (%) 100 110 11. a. Purchase a straddle, i.e., both a put and a call on the stock. The total cost of the straddle would be: \$10 + \$7 = \$17 b. Since the straddle costs \$17, this is the amount by which the stock would have to move in either direction for the profit on either the call or the put to cover the investment cost (not including time value of money considerations). 15-2
Chapter 15 - Options Markets 12. a. Sell a straddle, i.e., sell a call and a put to realize premium income of: \$4 + \$7 = \$11 b. If the stock ends up at \$50, both of the options will be worthless and your profit will be \$11. This is your maximum possible profit since, at any other stock price, you will have to pay off on either the call or the put.

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Chap015 - Chapter 15 Options Markets CHAPTER 15 OPTIONS...

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